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I decided to take a position in Pan Orient energy yesterday after the company released the following results from their L53-DST3 (L53-D EAST) Exploration well off the coast of Thailand.

Pan Orient is pleased to announce that the L53-DST3 appraisal well is currently on a 90 day production test flowing 38 API degree oil at a rate of 1,200 barrels per day through 8.8 meters of perforations between 1,142.7 meters to 1,163.2 meters true vertical depth (“TVD”), within an interpreted gross hydrocarbon bearing interval extending from 1,119 meters to 1,187 meters TVD with approximately 20 meters TVT of net oil pay.

This is the second successful well for Pan Orient in what they are calling the L-53-D prospect. The first well, which was drilled in early January, had equally good results.

Pan Orient is pleased to announce that the L53-D2 exploration well is currently on 90 day production test flowing 27 API degree oil at a rate of 1,015 barrels per day through 17.8 meters of perforations between 1110.8 meters to 1154.7 meters measured depth (860 to 890 meters true vertical depth), within one of six conventional sandstone reservoir intervals interpreted as oil bearing based on oil shows while drilling and open hole log and pressure data analysis.

It’s worth pointing out that these two wells are producing from different sets of sands. The first well produced from an interval 860m to 890 true vertical depth (TVD), whereas the second well produced from an interval 1,119m to 1,187m TVD. In the news release for the original L53-D2 discovery well Pan Orient described 6 potential producing zones:

the L53-D2 exploration well, drilled into the L53-D East exploration prospect, encountered approximately 65 meters of interpreted net oil pay averaging 20% porosity within five to six separate conventional sandstone reservoirs between the depths of 550 to 940 meters. This interpretation is based on numerous pressure data points indicating oil pressure gradients, oil shows while drilling and independent third party open hole well log analysis

Its too early to say whether all 6 zones will be as profilic as the first two appear to be. If they are though, this could turn into a major discovery for the little company.

About the little company

Pan Orient is pretty small, so it doesn’t take a huge discovery to have a big impact on the company. According to the January presentation on the company’s website, there are currently 56.7M shares outstanding, with a little over 60M fully diluted. As of the same presentation company has $58M of working capital, so there doesn’t appear to be any immediate financing concerns.

How much oil is there?

I’m somewhat confused about the prospective reserves in the L53-D prospect. The reason is that it is not completely clear whether the OOIP estimates being provided by various sources are for the L53-D block or for the entire L53 concession, and likewise it is not clear whether the OOIP estimates provided by the company were for one zone or for all 6.

From the company’s presentation, which was put out before either of the two discovery wells were drilled:

The company was assigning somewhere between 4.2MMbbls and 12.3MMbbls of oil ot the L53-D prospect.

A recent report from Paradigm (posted on the investorsvillage board, which is a great source of information on the company) suggested the following resource for the entire block:

The L53 fault structure is targeting 30–50 mmboe of potential recoverable reserves in three faulted compartments. Management believes each compartment has the potential to add 3,500 bbl/d

Where my confusion lies is that there is some suggestion that the resource estimates for the L53-D block only refer to a single set of sands, and that with 6 sands being intercepted there is actually a much bigger resource at stake.

This point was articulated clearly by an Investorsvillage poster algrovenew, who wrote the following:

I don’t think most people have fully grasped the significance of this discovery. The aerial extent might be limited, although still significant. However, what is really significant is the layering of the production zones. Take whatever aerial extent you want (2 to 6 sq. km, depending on whether the other fault blocks are saturated or not) and then multiply by 3 or 4 or 5 times.

The point that the pre-drill estimate may have been far too low was echoed in another post by sculpin, who I believe was posting a piece of a Paradigm note:

The L53-D2 discovery well and the L53-DST3 appraisal well have evaluated the first of three fault compartments of the L53-D East Structure. Results to date have been better than pre-drill estimates and could result in a substantial increase in reserves. The mid-case pre-drill resource estimate of the L53-D East structure is 7.4 million barrels (Figure 1).

What’s the discovery worth to the company?

As of the last reserve report POE had 32MMbbl of proven and probable reserves of which 7.4MMbbl is proved. Of note is that most of these reserves come from “volanics” which are reservoirs in offshore Thailand that have proven themselves prone to watering out and under-producing estimates. These new discoveries are more traditional sandstone reservoirs, which should be be deemed less risky by the market than the volcanics. Even the mid-point of the original prospective resource estimate (7.4MMbbl) would be a significant addition to reserves.

Pan Orient’s most recent P50 resource estimate for the L53-D East prospect is 7.4mbbl. The terms of the L53 concession are similar to Pan Orient’s core assets at L33/44, where Proven reserves are worth ~US$23.00/bbl (PV10AT, ~US$90.00/bbl crude pricing). On an unrisked basis, we estimate the L53-D discovery would be worth C$2.97/sh. Pan Orient indicates that it has at least two other fault compartments to test in the vicinity of this discovery, which would be additive to our unrisked valuation.

Pan Orient is not expensive

Even before the discovery Pan Orient was not trading at a high multiple. The company produced a little over $13M of cash flow in both the second quarter and the third quarter off of production of about 2,000 bbl/d. That puts the company at a trailing cash flow multiple of 5x, and at a trailing EV/boe of $90K. Of course with the two new wells the company will presumably be able to nearly double production, and as per the last news release they have plans to drill a number of development wells in the area starting in May, which should increase production further.

Buying a stock up 25%

I hated to buy the stock at $4.20 yesterday, up 25% for the day. I really had to plug my nose to do it. And it may turn out that I got carried away in the short run; I always find it difficult to can tell if a short term blow off top is upon a stock, and with further drilling delayed until May it may very well be that the stock settles back down into the 3’s before moving higher.

I am fairly confident however that the stock will eventually move higher. Even taking only what is current known, the stock should be able to trade at least a couple dollars higher as they drill more wells and bring production up to 6,000-7,000 bbl/d. If a few of these other zones prove productive, well then the potential is even greater.

Portfolio Performance:

Portfolio Composition:

Trades:

Europe to the sidelines (for the moment)

Eric Reguly had a worthwhile article in the Globe and Mail this weekend. He outlined the reasons why Greece and Europe are still as badly off as they were a couple of months ago. Apart from the markets perception, nothing has changed.

The basic problems in Greece, and in the rest of the periphery, he says, remain.

The country’s economy and its social fabric are unravelling at an alarming pace and the second bailout, combined with a sovereign bond haircut, will do next to nothing to stop the horror show.

So why is the market rallying when these problems have not gone away?

I think that there are a lot of similarities between the markets reaction to Europe today and the reaction of the market in 2007 and 2008. During the housing crisis, what drove the market down was not so much the fear of falling housing values, as it was the fear that falling housing values would cause banking problems.

At times, when it appeared that the housing problems were going to create only housing problems, the market rallied. When the spillover to the banking system was evident, the market fell.

There are different types of bear markets. There are bear markets that are economic and those that are financial. When an economic bear market hits, some sectors get hit hard, some get hit, and there are always some that actually don’t do too badly at all; the idea being that there is always a bull market some where.

When a financial bear market hits, everything goes down. Because in this case what drives the bear market is a lack of liquidity to buy stock. So all stocks fall. To be sure, this eventually hits the economy and causes a financial bear market, which happened in late 2008-2009 and compounded the problem. But there is a fundamental difference here in that during an economically driven bear market, though it may be more difficult a stock picker can still pick stocks. In a financial bear market you can’t pick anything and you just have to get the heck out.

How this relates to today is seen in how the market does not seem to care whether Greece goes into a severe recession. This is because Greece is an insignificant spec in the world economy. The market only cares if the problems in Greece spill over into the banking sector and cause banks to fail, not lend, seize up, and other worrying verbs, thus precipitating another financial bear market.

I wrote a long piece on the LTRO a month ago. As it turns out this has been the most popular blog post that I have ever written. This is somewhat unfortunate because this isn’t intended to be a blog about Europe, I am not an expert on macro economics or on banking, and the post is only tangentially related to the purpose of this blog; the stocks I own. At any rate, in the post I argued that the LTRO may have a short term psychological impact, but over the long run it wasn’t going to do much for the Greek, Portugese, Italian and Spanish economies because none of the problems those economies are having have been dealt with.

I still think this will be the case. Reguly highlighted the reasons why (referring specifically to Greece) in his article:

Labour costs remain too high. The economy is sinfully undiversified and laden with low-value industries, like stuffing tourists onto cruise ships. Corruption is rife. The tax-collection systems are primitive. The professional protection rackets – from truck drivers to doctors – remain intact. The country lacks a working land registry. The bureaucratic red tape leaves entrepreneurs and land owners in despair.

This is all really bad stuff. And its stuff that applies in large part to Italy, to Spain, and to Portugal. However, what is forgotten, and what I think I neglected in my post about the LTRO, was that while all this is true, it was also true a year ago, two years ago, long before Greece came to be a headline and before it began to cause markets to collapse.

The LTRO has accomplished an extremely important objective and that is that is has (temporarily) removed the mechanism for a banking collapse. The banks in Europe were on the precipice because they were overlevered (see my analysis of Deutsche Bank which remains levered at an insane 60:1) and they faced problems funding that leverage. Now, with the help of the LTRO, the banks are still overlevered but can get all the funding they want from the ECB.

Juggling Dynamite

I was listening to the Canadian money program Money Talks yesterday. The had Danielle Park, who writes the blog Juggling Dynamite, on as a guest. You can listen to the interview here by selecting the 10:00 am segment for February 25th. Parks basic argument is that this rally is a sham. Its built on liquidity, will die by liquidity, and there is no evidence that the economies of the world are getting better.

The main theme is the incoming recession… its already underway in Europe, Japan and the UK, what has been going the last several months is all about liquidity injections again, but the reality is it doesn’t fix things, we don’t have any solutions, debt has to be written off…

She argues that individual investors have to be very careful right now. They have to be careful about chasing the market up here, careful about jumping into dividend stocks to try to get a bit extra yield, and to be extra careful about fixed income because the yield you are getting there are miniscule. She has some very good comments about how dangerous the current environment is to the individual and moreover, how criminal it is that central bankers continue to punish savers and try to force risk averse individuals into risky assets.

Now, if you look at what I have done over the last few weeks, I have moved from almost 50% cash to basically no cash. So I must be completely at odds with her assessment right?

Wrong.

I think she’s dead on.

This is a false rally. This is a liquidity driven rally. This remains “the banks in Europe are not going to implode tomorrow so they must be worth more today” rally, which is not a positive pronouncement about anything other than that the end of the world is postponed.

CNBC had Lakshman Achuthan on this week to talk about his recession call from a few months ago. Last week I talked about how one of the indicators I follow, the ECRI’s WLI, was perking up, and that this perhaps portended to a strengthening US economy.

Maybe I have been too quick to look for confirmation. The counterpoint is that it is indeed simply a liquidity driven event. Achuthan also argues, much like Park, that it is. Central bankers are printing money and that money has to go somewhere. Real economic activity is weak and so the money goes into speculative investments instead. Achuthan said that given the amount of money being pumped into the system, he is surprised that the WLI has not risen more than it has.

Here’s the entire clip:

But what can you do?

So rally is on weak legs. Nevertheless, its a rally. If you recognize it as a liquidity driven rally then really, what you want to invest in (temporarily) is liquidity driven stocks. If you look at the stocks I am buying lately, they are exactly that. I am doing the right thing, even if perhaps I have not fully understood the reasons.

I like to call the junior gold explorers, companies like Geologix, Golden Minerals, Canaco, little liquidity eaters. The stock price of these sorts of companies have much more to do with the availability of liquidity then they do with the price of gold. That is plain to see by looking at a chart of any stock in the sector. Every stock suffered through 2011 even as the price of gold rallied hard. Every stock soared beginning in 2012 once the LTRO was announced and it became clear that liquidity would be in abundance again.

But these are trades. I do not expect to be holding any of these stocks 2 years from now. Absent some sort of paradigm shift like a move to the gold standard, these are stocks to hold for the run up and then cut loose when it looks like they are turning the taps off again.

But in the mean time, in the words of Jesse Livermore, from whom I stole my blog title and my avatar:

“But I can tell you that after the market began to go my way, I felt for the first time in my life that I had allies- the strongest and truest in the world: underlying conditions”

The underlying condition right now is one of liquidity. It is not the intent of this blog to philosophize (too much) on the eventual consequences of such liquidity. There are plenty of folks, like the wonderful Ms. Park, who are already describing those consequences eloquently. The intent here is to try to evaluate those conditions clearly, and to describe how I am acting to capitalize on those conditions.

I do not know if an 80-20 rule has ever been expressly stated for a portfolio. However I do feel that such a rule exists. Anecdotally, I am pretty sure my portfolio follows an 80-20 rule of sorts. 20% of the stocks I own are responsible for 80% of the gains. Or thereabouts anyways.

If you take a look at the gains in my current online portfolio you will notice the following:

Atna and Coastal make up a massive amount of my current gains.

Albeit this is far from scientific but it is not the first time that I have noticed that I make all my outperformance from a couple of stocks. In 2010, I’m pretty sure that most of my gains were due to Tembec, Mercer and Avion Gold, all of which tripled or better. In 2009, it was Western Canadian Coal, Grande Cache Coal Mirasol Resources and Teck Resources (call options), all of which rather insanely increased some 5x to 10x during the year. 2007 and the first half of 2008 was all Potash and Agrium (in the second half of 2008 nothing went up but puts and the dollar).

A couple of points come to mind:

1. Do more of what’s working

First of all, you have to know when you’ve got a winner and when you have a winner you have to add to it. I have done this of late with Atna. I bought more Atna this week at $1.30 after having bought more at $1.15 after having bought more at $1 after having bought more at 90 cents. I have bought it all the way up. I did the same thing with Coastal (though that acccumulation was unfortunately interrupted by the European fiasco) during the first half of last year, as it ran from $4 to $10.

Of course the obvious question is: Why not just buy more of the position at the start? It’s a great idea if you know the winners in advance. Unfortunately you don’t. At least I don’t.

I come up with lots of ideas. Some turn out to be really good ideas. Some turn out to be so-so. I’ve gotten better at it over the years, so less turn out to be full-on stinkers. Yet I still get a majority of so-so ideas that do nothing, and a couple winners that go to the moon. And I generally have very little idea at the beginning which one an idea is going to be.

Take for example PHH right now. This one feels to me like it could be the next big winner. It’s worked out so far. I have been adding some on the way up. But do I know whether the stock is going to be $25 or $12 6 months from now? Nope. It could go either way. Nevertheless when it hits $16 I will add more. And when it hits $18 I will add more again. If then, it gets to $25 it will be a big winner and I will be talking about PHH like I am talking about Atna and Coastal. On the other hand, if PHH goes back to $12, I will likely carry a much reduced position in the stock, if I am not out entirely.

2. Don’t give stock tips

This leads me to my second point. Giving advice on an individual stock, such sharing a stock pick with a friend or relative, or putting the name up on an investment board, is dangerous when taken out of the context of the portfolio as a whole. My portfolio has had between 12 and 20 stocks in it over the last 8 months. Unless I know which two or three are going to be the big winners (I don’t) then trying to give someone a tip is a losers game. There is an 80% chance (give or take a few percent) that I am going to give them a loser (or at least not the big winner)

I was out of Geologix for a couple of days (part of my sacrificial purge) but I decided to jump back in this last week after my thoughts on the liquidity situation crystallized. If we are indeed going to be liquidity driven for a time, then you might as well own the stocks most sensitive to it.

The PEA that was published on Tepal a few months ago put the NPV5 of the project at $412M based on $1000/oz gold and 2.75/lb copper. Geologix has $14M of cash on hand. With 145M shares outstanding, the market capitalization of the company was $28M at my entry price of 20 cents. That puts half the market cap in cash and the other half in a project with an NPV that is nearly 10x the value of the company. Something has to give here.

The market capitalization has increased since that time but its still a fraction of the overall NPV of Tepal. In other words, there remains plenty of room for the speculative elements to move the stock higher.

Tepal remains a fairly high start-up cost, fairly high operating cost, deposit that will only go ahead at a decent copper and gold price. Thus Geologix is acutely sensitive to the market perception of liquidity (it needs money to build the mine) and the future (Geologix needs high metal prices to make the mine economic). Whether it all comes together an the mine gets built is anybody’s guess, but so long as the liquidity is a flowin I believe the market will be inclined to look positively on the potential, while ignoring the risk.

New Drill Holes

On February 16th Geolgix announced the results of infill drilling at Tepal. There were some higher grades in these result (though we are still talking about extremely low 0.7-0.9 g/t grades). Below is a cross section that identifies a couple of the higher grade holes against the lower grade historic holes.

As you can see from the intercepts, the deposit does hold together rather well across a long length. In addition, the North deposit, where the mining will start, takes well to the shape of a pit. If it wasn’t that the grades were so low, it would be quite a nice little deposit.

The higher grades in these recent holes do perhaps bode favourably for better economics early on. That could help the NPV of the project. As stated by the CEO of Geologix in the news release:

“We are pleased with these latest results as eighty (80) of the last ninety-one (91) holes being reported encountered mineralization equal to, or greater than the Company’s internal North Zone cut-off and represent the final data required to complete the upgraded resource estimation currently being conducted by Micon International Limited. Additionally, multiple holes drilled within the central portion of the North Zone returned intervals of gold and copper grades well in excess of the 2011 Preliminary Assessment North Zone’s mine plan average grade of 0.37 g/t gold and 0.24% copper. These elevated grades found over substantial intersections support the potential for the North Zone to host a sizable higher grade starter pit which could positively impact Tepal’s production profile, specifically within the critical early years of the project’s mine life.”

Bottom Line

I’m still unsure whether Tepal will ever become a mine or not. It just seems like such a low grade. It will inevitably put the company on a knife edge between being profitabilty and cost overruns, and wil require an able operator with a strict eye on the budget. Every mistake will be amplified. Nevertheless, the mine is not yet built and so that is not really my concern. In this period of liquidity, I am willing to put some dollars into Geologix on the expectation that the market will push the stock back up to its pre-euro-crisis levels in the 60 cent range. This does not seem unreasonable given that the case can be made that in a perfect world Tepal would be worth $3 per share. Its kind of like Greece and the rest of Europe: why worry about tomorrow before its here?

Jumping on the Bandwagon

As I wrote about earlier, I am coming around to the view that the US economy will perform reasonably well over the next few quarters.

Now let us not confuse the short term with the long term here. I don’t for a moment think that the longer term issues in the US have been solved. The situations in Europe, in Japan, and in the US are very similar. There are massive storm clouds on the horizon, and those coming storms are causing the winds to pick up and the boats of the economy to waver in the seas. But the storms themselves have not yet reached us, and so while we may have bouts of turbulence brought on by rising winds, or even, as in the case of Europe in November, sudden gusts that threaten to capsize the rigs, the actual storms are still a little ways off in the distance, far enough that we can pretend at times that they are not there.

Now appears to be one of those times.

The LTRO seeming to have stabilized the banks of Europe in the near term.

TED Spread:

Italian 10 year:

Spanish 5 Year:

The economies of the European periphery, while entering what has to be an inevitable and deep recesion, are still far enough away from the consequences of these (maybe 2-3 more quarters) that we can ignore that more bailouts or a mass exodus from the euro is close at hand.

Finally, there can be no doubt that the numbers in the US are picking up some steam of late. How long will this continue? Perhaps not too long, but who is to say.

More specifically, the housing sector has been beaten to such a pulp in the past few years, and the stocks involved have taken such a beating, that even a stabilization at these low levels (both prices and activity) may lead to a substantial uptick in the share prices.

Always on the look-out for a bull market

So while I don’t really believe it can last over the long term, that doesn’t mean I can’t take advantage of it. In the absence of the arrival of a true storm (like what happened in 2008), there is always some bull market somewhere. You just have to find it.

Where am I looking?

US Regional and Community Bank stocks

Mortgage Servicing companies

Oil stocks with large resources that can take advantage of Hz-multifrac technology to exploit those fields

I still don’t know what to think of gold. There is a bull market out there, but only for select stocks (see Atna and Argonaut Gold for a couple of examples).

Buying into Newcastle and buying more into PHH

As I wrote earlier, I believe that the mortgage servicing business provides a unique opportunity right now, and while I have started a position in Newcastle Investments in response to that, I expect to increase that position substantially over the coming weeks. I have also turned PHH Corporation into one of my largest positions.

I’ve already talked about both of these investments ad nauseum in the last couple posts so I am not going to reiterate those theses here. What I will say is that I am becoming more and more cozy with the mortgage market bottoming idea and I would expect that you will see more of my capital make its way over to this market in the coming weeks. I am already looking for an opportunity to exit OceanaGold and reduce my position in Aurizon Gold. The proceeds are likely to either go into PHH or NCT, or into another mortgage leveraged corporation that I find.

If you remember, I sold both Arcan and Second Wave a week ago Friday. That lasted about a day and a half.

Sometimes selling a stock can make you think about it more clearly. Such was the case with both Arcan and Second Wave. In fact I spent last weekend working through their prospects. I hope to post on this soon, but for now, let me just say that the work reiterated to me just how much potential these two companies have.

The main reason for not owning both of these Beaverhill Lake producers is because they are spending a lot more then they are taking in.

They really have been spending a lot more than they take in. The original reason I reduced my position in both companies last fall was because with Europe appearing on the precipice, being invested in companies in need of capital seemed like a poor proposition.

However Europe seems to be back on the back burner. For Arcan and Second Wave, spending a bit more then you make is not such a bad thing anymore. It can actually be perceived as a good thing; growth and potential and all that jive.

The reality is that the prize at Swan Hills continues to prove itself up, and the NAV of both companies will likely continue to rise as they drill more wells.

Perhaps the kicker for me was the news release put out by Second Wave last Monday. In the release SCS announced a number of new boomer wells in and around the existing boomer wells that they (with the JV with Crescent Point) and Coral Hills have been drilling. But more importantly, SCS announced the success of a well drilled far to the south of this existing “sweet spot”:

[Second Wave] completed its 100% working interest 01-17-062-10W5 Beaverhill Lake light oil well in south Judy Creek with an initial two day flow test rate estimated at 800 bbl/d of light oil further delineating the Company’s south Judy Creek land base.

The 01-17 well (big red circle) is well to the south of the existing sweet spot and it opens up a whole mess of land in between. A lot of those southern sections are 100% interest for SCS as well:

While we are somewhat away from proving up the sections in between, the 800boe/d success gives me a lot of confidence that they will be proved up over time.

I ran the cash flow numbers on 2012 based on their expected average production of 3,850 boe/d and $95 oil and I figure they can generate around the $85M mark of cash flow. I will post that cash flow analyis more thoroughly in a later post. For now, suffice to say that my estimate compares favorably to the $85M CAPEX estimate that the company had in their February presentation. Perhaps the days of spending in excess of what you make are soon to be over for Second Wave?

Future Catalysts?

I see a couple of catalysts for Arcan and Second Wave that made me want to stay out of the stocks.

I think that the biggest catalyst to get me back into both stocks in short order was the spector of the upcoming reserve report of both companies. I suspect that the reserves for both Arcan and Second Wave are going to show some excellent numbers, potentially with NPV10 estimates decently above the current share prices.

Arcan has the additional catalyst of the waterflood of Ethel. I posted late last year how quickly Ethel production was declining without waterflood. I wrote:

If you look at the average Ethel and DMU production curve, you can see the effect of the waterflood taking place at DMU versus Ethel. Ethel wells do appear to stabilize at a lower level. The following chart looks strictly at horizontal Ethel and DMU wells drilled after Jan 1st 2010 (I didn’t want to confuse things by adding data from old completions) averaging out the monthly production for all wells at that point in their decline. Producing day rates are used.

Now it has to be pointed out that the post 6 month data for Ethel is a single well (the 10-27). So we are not dealing with a large dataset here. Still, I think the conclusion can be made that Ethel wells drop off quicker and stabilieze at a lower rate without the waterflood.

Presumably with waterflood one would expect that Ethel type curve would shift up to where the DMU curve is. One mitigating factor to this improvement might be reservoir quality. The sands at Swan Hills have often been thought to thin to the south. On the other hand, Arcan’s completion techniques have improved quite dramatically lately with the move to the larger acid fracs (another detail that was provided in the Q2 MD&A). This is witnessed by the significantly higher IP30 and IP60 results produced by these presumably thinner sands at Ethel. So this may help the Ethel wells outperform.

Its a bit of a guessing game until you get some data.

So what does it mean to production? Two things. First, with the waterflood implemented you would expect that the existing wells at Ethel would deliver a higher rate. I’m going to speculate that, on average, this would be about 40bbl/d for the post 2009 drills. This would add about 350bbl/d of production to Arcan.

Since that time Arcan has drilled a number of additional wells at Ethel. I would estimate that once in full operation, if the 40 bbl/d per well increase number holds up one could expect around 500 bbl/d extra production from Ethel. But it could be more, and at least in the short run, likely will be more.

In my week 29 letter I began to talk the opportunity I was seeing in mortgage origination and servicing.

While an uptick in new home building may still be some time away, mortgage origination should benefit over the next year from the refinancing associated with HARP II and from less competition due to the exodus of originators from the ranks brought on by the dismal market conditions.

Mortgage servicing, meanwhile, has been hurt by falling interest rates (remember that as a servicer you get paid as long as the loan is being paid, so refinancing can hurt your business if you can’t reoriginate the refinancing), by uncertainty in the regulatory environment, and by the regulatory capital concerns of banks. But valuations on mortgage servicing rights are low and with loan quality standards currently high and with interest rates unlikely to go lower, new servicing rights should be a good investment.

I want to delve a little deeper into the mortgage servicing rights (MSR) part of the business this week.

What is a mortgage servicing right?

A mortgage servicing right is a somewhat complicated little piece of paper of conditions, responsibilities and payments. For the basic definition I will defer to investopedia:

An MSR is a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.

In return for these responsibilities, the servicer is entitled to a small piece of the recurring interest payments made by the borrower, usually around 25 basis points (0.25%).

A more investment oriented definition of an MSR comes from kamakuraco, who published an interesting paper on estimating the risk of an MSR, and who define the mortgage servicing right in the terms of a security:

One can approach the valuation of mortgage servicing rights as the valuation of a fixed income (broadly defined) security subject to default risk and prepayment risk.

There are two risks implicit to an MSR; either the mortgage is paid off, or the borrower defaults. In both cases the payments to the holder of the MSR are no more.

The collapse of the MSR

There was a great discussion two weeks ago on the Lykken on Lending mortgage banking podcast. Lykken had on Austin Tilghman and David Stephens, CEO & CFO respectfully, both with United Capital Markets. These fellows are industry experts in the mortgage servicing market. The discussion begins about a half hour into the podcast.

To take an aside for a second, I have to say that listening to the discussion brought about one of those exciting moments that make investing fun. I was biking home from work, had my ipod on listening to the broadcast. The roundtable discussion with the UCM execs came on and the second question, put forth by Alice Alvey, asked why are company’s beginning to retain their own servicing rights when traditionally most originators just sold those rights off for the cash up front? Austin Tilghman (I think. He didn’t identify himself) replied with the following:

Prior to the meltdown the price paid for an SRP [servicing release premium] was generally 5x or more of the [mortgage] service fee. That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.

Andy Schell, Lykken’s partner, then went on to say that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.” He reiterated that the SRP’s are in some cases approaching zero.

Wow.

When I hear that kind of disconnect I immediately think opportunity. And then I think how can I capitalize on that opportunity.

Defining SRP’s (there are too many acronyms in this industry)

But first of all, another definition. When a company originates a mortgage, along with that mortgage comes the right to service the mortgage. That’s the mortgage servicing right.

As an originator you have the option to keep the MSR on your book and service the mortgage through its life in return for the 25 basis point (or thereabouts) premium.

Alternatively you can capitalize the MSR up front by selling it. In return for selling the MSR you get cash. The cash you get is referred to as the servicing release premium (SRP).

The acronyms MSR and SRP get used all the time in discussions without definition so its good up front to understand what these two concepts are.

Why SRP’s have collapsed

As David Stephens alluded to above, the value of an SRP has collapsed of late. A few reasons why this is the case:

There is concern about a regulatory change to make MSR’s a fee for service as opposed to a tacked on percentage of the loan interest (this is preventing new participants from getting into the market but it appears that it is not going to happen)

There is a more nebulous concern about the regulatory environment in Washington in general and what the “unknown unknowns” of future legislation might be

You only get the cash flow stream of an MSR over time whereas you get cash right now by selling the SRP and has of course been a liquidity problem in the industry since 2007

Its a long term commitment to get into servicing. You can’t just jump in overnight without getting approvals as a servicer from the regulators and developing the infrastructure to do the servicing

The market for buying and selling servicing is thin at the best of times and especially thin now (because of all the folks getting out of the business)

And that is because… no bank wants to have anything to do with the mortgage industry

The opportunity

The basic investment premise here was well put on the broadcast by Joe Farr, who asked the following question:

With rates at 3.5% or 4% and quality never being better, why is it that that servicing values are close to zero in some cases?

To which Austin replied:

Its the aggregation of the aggregators. In 2007 an originator might have 20 take outs for the loan they produced. After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts. Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market. And they have their own capacity limitations. It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

And there you have it. A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

Who is going to benefit?

So I own a bunch of PHH now. They are big time servicer and the MSR’s on their books are valued at about 2.7x. Clearly from a book value perspective PHH has some upside to that servicing valuation if interest rates begin to rise and they can value that servicing at something closer to 5x. Servicing values have had to take major writedowns over the past 3 years as defaults have increased and more importantly, as interest rates have fallen, raising the possibility of refinancing. I found that really interesting table of the writedowns taken by some of the major banks over the past 3 years in the Kamakura report that I mentioned earlier:

That is nearly $30B in writedowns over the past 3 years for the 8 major banks. Wow.

Remember that the writedowns are being taken in part because the current MSRs are expected to refinance at a faster rate. PHH has, in the past, managed to retain most of their servicing rights that get refinanced by being the originator on those refinancings. So its perhaps a little misleading to value those servicing rights at 2.7x.

To get an idea of impact of a revaluation of those MSRs on teh PHH books to a 5x servicing fee multiple:

Ok, so that’s a pretty big impact on the accounting end.

As I already mentioned, PHH has proven that they can produce more MSR’s then they lose even during times where a large amount of the MSR’s are refinancing. The new MSR’s replacing the old MSR’s are of a much higher quality. By high quality I mean that these MSR’s are connected to mortgages that are being financed at extremely low rates (and therefore where the chance of early repayment is low) and within a market where credit quality is extremely restrictive (meaning the chance of default is low). This doesn’t seem to be reflected anywhere in the books.

So PHH has some upside as MSR come back into favor. That’s good. But there are two problems with using PHH as the vehicle to play the MSR disconnect:

They don’t have the cash right now to take advantage of the disconnect in price and buy up MSR’s on the cheap. What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

They are an originator, so when the MSR’s begin to recover their value its going to be on the heels of rising interest rates which will hurt the PHH refinancing business. In other words, PHH will never have all cylinders firing at once.

What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

Enter Newcastle Investment

I have owned Newcastle investment in the past. In fact, I owned them as recently as last summer, but I sold them in one of my “sell everything because who the hell knows what is happening in Europe” moments. At the time, I owned Newcastle because they, much like Gramercy Capital, had a large disconnect between the NAV of their managed CDO portfolio and the share price.

I’m not going to go through that CDO valuation right now because I want to talk about the MSR business that Newcastle is branching out into. I probably will in the next few weeks, just to get a better idea of the value proposition here. In the mean time the best places to find a comprehensive analysis of Newcastle’s CDO business are on the Gator Capital blog and the analysis by PlanMaestro on variantperceptions here and here.

The essence of these analyses is that if you add up the CDO business and cash at corporate, subtract out the preferred’s and other debts, you get a company with an NAV of about $5-$5.50 per share. So your net asset value is something pretty close to the current share price.

Here’s the crux then. Of that $5-$5.50 per share net asset value, about $205M (or a little less that $2 per share) was cash at the end of the third quarter. The potential upside exists if Newcastle can turn that cash into a cash producing asset that has a value greater than the face value for which it is purchased.

NCT gets into the MSR business

On its third quarter conference call Newcastle made the announcement of the change in direction. The company was getting into the mortgage servicing business. The company said it would be making major investments into MSR’s over the next few quarters (one of which they have already since announced). The reasons that they decided to make the switch in strategic direction was:

They felt the MSR business offered the best risk adjusted returns out there

The existing core business of CDO creation was basically dead

Interestingly, Derek Pilecki, who writes the Gator Capital blog, dumped NCT when the news was announced. While I am of the mind that getting into the servicing business right now is a savvy move, I recommend reading his final analysis of (and reasons for selling) Newcastle here for a contrary point of view.

We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.

Newcastle went on to describe something that the fellows from UCM pointed out on the Lykken broadcast; how banks are basically dumping their servicing business on the cheap. Again from the transcript of the 3rd quarter conference call:

Banks in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, [and this has] made them more likely to be source [of MSR supply]

To get into the business Newcastle is partnering with an originator and servicer (Nationstar) and Nationstar will be performing the actual servicing. I think that Newcastle can be thought of as a silent partner that is putting up the cash. Again, the problem with MSR’s is that you have to have the cash to put up, and while most originators are running a tight cash flow, Newcastle has ample cash to take advantage of the investment.

Newcastle has also received approval from the IRS that MSR’s can receive the same favorable taxtreatment as other REIT assets.

That they had to clarify approval demonstrates the “first mover” status that Newcastle holds. Newcastle is early on in the game, being one of the first REIT’s to take advantage of this opportunity. As one of the analysts put it on the Q&A, Newcastle is “leading the way”.

What’s the upside?

The upside to Newcastle is a big increase in the free cash flow that the REIT can generate. Before getting into the MSR business, Newcastle was generating around $80M of free cash flow (FCF). At a 20% return on the $200M of unrestricted cash (using the assumption that the company puts all its free cash into the MSR business), you are looking at FCF of another $40M. Given the current market capitalization of $600M that puts NCT at a 5x free cash flow multiple. The company paid about a $60M common share dividend in the third quarter, so clearly another dividend hike would be likely.

“I am very pleased to announce our first investment in Excess Mortgage Servicing Rights. This is a watershed investment for us in this sector. We expect this investment will generate approximately a 20% unleveraged return and total cash flows of over 2 times our investment. I am excited to be investing alongside Nationstar, a premier mortgage servicer and originator. Residential mortgage servicing is a large market and we currently see a strong pipeline of similar investments at very attractive returns.”

The deal was for $44M.

In my opinion, apart from the basic cash flow expected there is unrealized value in these MSR assets. For one, because Newcastle is partnering with an originator in Nationstar, there is a good chance that a decent percentage of the MSR’s that the company is investing in will be refinanced through Nationstar. Newcastle was quick to point out that refinanced mortgages remain in the portfolio and continue to cash flow to Newcastle. The refinanced value is not included in the value of the MSR. Newcastle estimated the following refinancing rate on the Q3 call (from the SeekingAlpha transcript again):

So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it wouldn’t be prudent, but at the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, as the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.

Second, as I already pointed out, recent and new MSR’s are being collected from mortgages that have been financed at historically low rates and in an era of extremely strict lending criteria. There is little chance that these mortgages are going to default and little chance that they will be refinanced any time soon. In other words these are high quality assets.

Its kind of a weird perfect storm here; you have a situation where the asset quality has never been better at a time when nobody wants the asset. While I suppose its not clear exactly what the quality of the MSR’s Newcastle is investing in are, if one presupposes a little faith in the management team (which has after all had the foresight to see an opportunity that many others have not yet seen), you might draw the conclusion that Newcastle is getting into high quality assets at a fraction of their underlying value.

Anyways if you add it all up I think NCT is on to something here. I bought a position in the stock and plan to add to incrementally as the stock moves up and my thesis is proven right.